What is a Proprietary Deal?

In a recent conversation with a partner in a private equity firm, he mentioned that a recent deal had been a “proprietary deal.”  I had not heard the term before, so I asked what he meant.  When he told me, I was already familiar with the concept, just not the term.  I learned that proprietary deals have some or all of the following characteristics:

• The potential buyer engages a seller, suggesting that dealing with a single buyer will be more efficient, less expensive, less frustrating, and, if the buyer is the “right one,” will provide a better fit for the selling company and major owner(s) than some unknown other party that might surface if the deal were “shopped” in an auction.
• The seller likes the potential buyer, who is nice and attentive and seems interested in the seller on both personal and professional levels (and, of course, may be).
• The buyer is encouraged to negotiate with the single potential seller (who is quite experienced in making acquisitions) without the benefit of financial advisers.
• Some sellers do negotiate with a single potential buyer, and deals are struck.

This post examines the concept of proprietary deals primarily from the sellers’ viewpoint and suggests that, even if a seller deals with a single buyer, he or she is well-advised to get good financial  and deal advice.

Are Proprietary Deals “Fair, from a Financial Point of View” in Public Deals

I have had the opportunity to work with many sellers and buyers, many of whom were public entities, on many occasions over the last 30 years.  When our firm represents sellers, we (almost) always suggest that a form of an auction process be employed.  Price may not be everything in a particular deal, but it is best to negotiate the other deal issues with potential buyers who are already offering a reasonable, or even unreasonable, price.

Auctions are designed to get the highest available price in the market at a time when a company is in the market.  When investment bankers look at the financial fairness of deals in rendering ”fairness opinions” involving public companies, they must examine not only thepricing and terms of a negotiated deal, but also the process through which it was developed.  Based on their analyses, financial advisers develop fairness opinions which conclude that deals are “fair from a financial point of view.”

To be “fair, from a financial point of view,” the agreed upon price/terms must be evaluated in the context of the process through which they were developed.  If there is a single bidder for a company requiring a fairness opinion, the financial advisers must convince themselves that, in spite of the lack of active marketing (or an auction process), the financial advisers should determine (analytically or otherwise) that the price being offered is in the range of what I call “preemptive pricing.”

Preemptive pricing is normally associated with low-ball pricing to attempt to keep other competitors out of a market.  Preemptive pricing has a corollary meaning when talking about the acquisition of businesses.  A “preemptive” offer is one that should clearly be at least in the range of likely prices to be obtained in an active auction process.

In terms of fairness opinions, preemptive pricing in single-buyer deals is pricing in a range that the financial advisers believe, based on their analysis and experience, would likely have developed if an active marketing or auction process had been employed.  Investment bankers and financial advisers attempt to determine this range of pricing through analytical processes and through the application of market knowledge.

What About Private Deals?

Why do I talk about fairness opinions and fairness, from a financial point of view?  Because private company owners should think in terms of fairness (to themselves and to their fellow shareholders), as well, and consider the likely price and the expected process if they become involved in a proprietary deal.

The reality is that in proprietary deals, preemptive pricing is exactly what the buyers are attempting to avoid.  One “proprietary deal flow consultant” says the following to its private equity prospects [with comments]:

Proprietary deal flow is acquisition prospects for which you are the only bidder [no competition]. You know they will fit your strategy and criteria because you choose them yourself. You will be the only bidder because they are not actively seeking a buyer [and haven’t engaged a financial adviser]. However, they have sound reasons to consider a sale, reasons that have nothing to do with the expectation of an excessive price [i.e., the proprietary deal purchaser seeks a price well below “excessive”].

TASC believes proprietary deal flow produces significantly better results [for private equity buyers, meaning lower prices for sellers] than reacting opportunistically to companies offered for sale. Just because a company is seeking a buyer is no reason to assume it will meet your needs in seeking an acquisition. Even if it does, there is a high risk it will have found a buyer before you find it. If it hasn’t, the whole process of offering a company for sale is designed to create an auction [of course], to produce the highest possible price [yes, or to identify a range of attractive prices and terms for selection by the buyer]. The end result for you can be wasted time, hurried decisions, frustration or worse. Proprietary deal flow normally avoids all this.

One Writer’s Take on Proprietary Deals

John Warrillow, author of Built to Sell, warns sellers about proprietary deals, noting a number of likely results from not engaging in a fuller process with the benefit of appropriate financial and deal advice.  He notes:

Falling victim to the proprietary deal is easy. You get approached by a partner in a PE firm or a senior person from a big company in your industry you know and respect. They shower you with compliments about your business, invite you to a fancy lunch and then ask if you’d consider selling. Once you agree to a conversation, they convince you there is no need to involve an advisor to represent you – why pay the money, they’ll say, to some guy or gal who has done nothing to help you build your business – we’re friends after all.

But becoming the mark in a proprietary deal is much more expensive than having your wallet pick pocketed by a street crook. Here are five reasons to avoid being the target of a proprietary deal:

He then goes on to state the following (in bold), with a comment or two from me:

• You’ll get a lower price.  Have you ever been to an auction?  Have you ever been personally “involved” in an auction where you were an active bidder engaged in the process?  If so, you know that you paid a higher price for the item(s) than you would have otherwise paid in the absence of competing bidders.
• Due diligence becomes protracted.  Absent competition, the buyer is not in a rush, and will cause sellers to sign an exclusive agreement to preclude further shopping.  I heard an expression years ago that “Time wounds all deals.”  Protracted due diligence allows time for the sole buyer to find things that will hurt the deal, leading to Warrillow’s next point.
• Shrinkage.  If the buyer finds something that will cause them to want to lower the already agreed upon purchase price, there is little opportunity to counter on the part of the seller, and the buyer may demand a price reduction.
• Seller’s remorse.  The gist of Warrillow’s discussion is that absent some degree of considering other potential buyers, the seller in a proprietary deal may always look back and wonder whether he or she got a fair deal — remember my comments above about fairness opinions.
• Out of market terms.  So the buyer doesn’t tinker with the “agreed upon” price.  They may push for terms that have the effect of diminishing price, including unusually large escrows held for longer than normal times, thereby increasing the likelihood that something will go wrong and the purchase price will be diminished.

Although Warrillow doesn’t say it in his short post, the probability of one or more of these things happening in a proprietary deal is greatly enhanced if the seller does not have competent financial and deal advisers.  If a sole buyer advises you (or you client) that you don’t “need” to hire a financial adviser because that would only confuse their friendly negotiations with you, run, don’t walk, to hire one!  The presence of a competent adviser raises the prospects of future marketing and decreases the probability of a single buyer being able to take advantage of the process that they created.

Balancing the Scales and Putting the Wrapper on Proprietary Deals

If you are approached by a single prospective buyer who wants to deal exclusively with you (or your client), take a few minutes and enjoy the flattery.  Then rush out and find an experienced financial adviser to work with you.  Advisers charges will vary, but, depending on the size of a deal, will range from less than 1% of a transaction price to 3% to 5% for some deals (or even a 10% brokerage fee for very small businesses).

If these fees seem expensive, just know that buyers who seek proprietary deals are looking for price advantages that begin at 10% less than competitive pricing and rise from there.  Hiring an experienced financial adviser will balance the negotiating scales for you.

Your financial adviser, even in a proprietary deal, can simulate a competitive process and provide the very real threat of walking away and engaging in an auction process.  Sometimes, the “right buyer” comes to the table first.  They won’t leave if you hire a financial adviser.  After all, if they can succeed in keeping other buyers away, even if they have to pay a competitive price, their odds of completing the deal rise from very low (in an auction) to very high in your “assisted” proprietary deal with them.

Warrillow concluded his post with these comments:

At first blush, negotiating on your own with one buyer can look simpler. Life is short after all and you might argue it’s better to make a quick sale to a friendly buyer even if you leave a few bucks on the table. But the illusion of the easy deal can quickly turn into what amounts to a one-sided swindle.

Forewarned is forearmed.

The headlines for the Wall Street Journal Weekend Edition (August 24, 2013) read regarding August 23rd surprise announcement:

CEO EXIT Sets Microsoft on New Path
Steve Balmer, Who Faced Criticism Over Waning Growth, to Leave Within a Year; Stock Jumps 7%

The thought of a blog post was instantaneous.  I’m writing about management and ownership succession/transition planning and on this blog, and then a CEO makes a surprise announcement and Microsoft’s (MSFT) shares jump from $32.39 per share to $34.75 per share, or 7.3%.  Was Microsoft really worth $20 billion more following this unscheduled announcement?

Probably not, but the price movement apparently reflected substantial pent-up frustration with Microsoft’s direction, or lack thereof, and its ongoing market share and market capitalization relative to the likes of Apple (AAPL) and Google (GOOG).

Executive Suite Reshuffle

Mr. Balmer is the architect of Microsoft’s relatively new “devices and services” strategy.  His announcement was preceded by a reshuffling of the chairs on Microsoft’s proverbial deck:

Microsoft said it would look both inside and outside the company for a replacement as Mr. Balmer remains CEO for up to 12 months.  The surprise announcement suggests that there was no planned succession, coming only about six weeks after Mr. Balmer shuffled his entire executive suite with naming a clear No. 2.

No planned succession for Microsoft, one of the leading companies in the world with a market capitalization of nearly $300 billion?  What kind of example is that for the boards of other public companies or for the boards of closely held and family businesses?  Well, they have been looking, unsuccessfully:

Executives inside and outside Microsoft said change at the top of the company was long overdue.  People briefed on Microsoft board deliberations said directors have scouted for years potential successors to Mr. Balmer.  But those people said it has been tough to find the right replacement to lead a sprawling company that has only had two CEOs in its history.

The Strategy Unfolds

Just a few days later, on August 30, 2013, Microsoft announced it will acquire the mobile phones and smart phones divisions of Nokia, a further push into the devices and services strategy.  The deal was about a $7 billion transaction.  However, what the market “gaveth” upon Mr. Balmer’s announcement, it “tooketh away” with the Nokia announcement.

Nokia, which has had substantial problems in recent years, saw its shares jump nearly 50% in pricing.  Microsoft shares, on the other hand fell from $33.20 per share to $31.90 per share, or 4.5%.  Clearly, the market is questioning the devices and services strategy.  While the markets were receptive to Mr. Balmer’s announced departure, they do not appear to be receptive to his continuing that strategy during his lame duck period.

Now, just over two weeks following Mr. Balmer’s announcement, as luck would have it, there has been exactly no net change in Microsoft’s share price.  Pre-announcement and as of September 10, 2013: $32.39 per share.  The Balmer Premium has vanished. But a lot of money was made and lost during the interim.

6 Thoughts re Inevitable Management Transitions

Let’s set aside the issue of strategy for a later time and focus on the issue of management transition for closely held and family businesses.

Market caps in this sector may not range to $300 billion, but the market caps are very real and very important to their owners.  Our clients range in market cap of equity from perhaps low millions to multiple billions.

The situations in this range of companies may differ significantly.  What does not differ is that, like Microsoft, they all face important management transitions.  For some the transitions are imminent, and for others, less so but coming.

Here are six thoughts or lessons for the owners and key managers of closely held and family businesses:

1. Management transitions are seldom easy, and they take time and focus from the right people, including you, your board of directors, key advisers, and, perhaps, certain key insiders.  The process was not really initiated at Microsoft in nearly enough time.
2. It is important to think about and plan for inevitable management transitions well in advance.  While a number of Microsoft insiders were no doubt thinking about the inevitable transition from Mr. Balmer’s leadership, no one was planning effectively.  A major management reshuffling just prior to the announcement is evidence of lack of planning.
3. Don’t run off your best contenders for succession before you begin to take action.
4. Remember that if you are thinking that a management transition might be needed, everyone else knows it should have begun or even happened already.  Perhaps that is the cause of the buoyancy in Microsoft’s share price at the Balmer announcement.  
5. It is difficult for your team to focus on any strategy if all of the members are wondering what you and the board are going to do for too long.  What must the top executives at Microsoft have thought about the recent realignment noted above where Mr. Balmer (and Mr. Gates and the entire board) allowed this restructuring without naming a Number 2?   
6. You and your board have a responsibility to plan for and to implement management transitions in a timely manner.  Management transitions are important for your shareholders, your employees, your customers, and, indeed, all of your company’s constituents.  Microsoft’s CEO and board have put themselves in a position with a gun to their heads.  Mr. Balmer will stay on for another 12 months.  What if a successor is not found?  What if the internal pressures are so great that a decision is made too rapidly?  

Many of the companies I deal with have baby boomer senior managers who own substantial portions of their companies.  Let’s put ownership transitions aside for now.  Every one of these companies will experience management transitions over the next one, two, five or ten years or so.

Isn’t it better to plan ahead for these critical transitions for the good of your fellow owners, their families, your employees, your customers and on?  Of course it is.

So don’t be caught like Mr. Balmer and Microsoft’s board, in a trap with no apparent solution.  Read the lessons above and take action.  If you want to talk about some of these important issues you are facing, give me a call (901-685-2120).

But don’t expect an automatic 7% increase in your appraisal!

Shortly after the turn of the century (!), I started work on my first book on buy-sell agreements. That book, Buy-Sell Agreements: Ticking Time Bombs or Reasonable Resolutions?, was published in 2007.  That same year I gave a major presentation on the topic at the annual conference of the Business Enterprise Institute in Denver.   It was fun and I received several additional invitations to speak afterwards.

During that almost two-hour presentation, I provided two slides on an idea I called “The One Percent Solution.”  I developed the term as a vehicle to talk with clients about the value of valuation and other financial and estate planning activities conducted to manage (pre-liquid) private company wealth.  The gist of the idea is simple:

Consider a budget for managing your pre-liquid wealth (defined as your ownership interest in your private company) similar to the fees you pay to manage your liquid wealth (stocks, bonds, other liquid investments).

When thinking about investing to manage your pre-liquid wealth, consider how you likely manage your liquid wealth:

• Holders of liquid wealth, including stocks of public securities, bonds of many kinds, securitizations of assets and other assets with active or relatively active markets tend to place them “under management” with financial planners, money managers, investment advisers or other professionals who manage their wealth actively.
• Asset managers charge fees for their services. Equity managers might charge 100 basis points, or 1%, of assets under management. Bond management fees tend to be lower, say from 20 to 50 basis points or so.  And private equity, venture capital, and hedge fund fees tend to be higher, perhaps 1.5% or higher.
• If you have a million dollars in managed, liquid funds, even in your company’s profit sharing plan, you are likely paying fees of 75 to 100 basis points for the services of your asset managers.  You and I and almost everyone else with significant liquid wealth does the same thing, so on your million dollar account, you are likely paying fees of perhaps $10 thousand, or say 1% of “assets under management,” or AUM for short.

Pre-liquid assets either become liquid or facilitate the creation of liquid assets when they are sold (entire businesses or partial sales) and when they distribute cash to their owners. Do owners of privately owned companies typically thing about their pre-liquid assets as investments? Not if our experience is representative. This leads us to The One Percent Solution.

The One Percent Solution Defined

So what is The One Percent Solution?  Consider 1% of the wealth tied up in your (or your clients’) private businesses as the starting point for discussion for the budget for managing that wealth.  So if a closely held or family business is worth $20 million, the budget for managing that wealth might be about $200 thousand, or about $100 thousand if you use 50 basis points as your “management fee” percent.

The Booklet

During that speech in 2007, I said no more than what I’ve written above about The One Percent Solution.  However, a few months later, I received a call from a sales manager with National Financial Partners. I thought he was going to ask me for a repeat of my buy-sell agreement presentation.  While he found that talk very helpful, he was most interested in a one-hour presentation on, you guessed it, my two slides regarding The One Percent Solution.

I delivered that presentation and also wrote a booklet on the topic for each financial planner at the conference. That booklet is available today as a complimentary pdf download. Financial planners have purchased the book in bulk to give to their clients and I have given a number of speeches on the topic.

A New Book In New Series Is Coming

Because I am a member of the baby boomer generation and because I am a transitioning business owner, I am keenly interested in succession planning for baby boomer business owners. As such, I have begun a new series of Kindle books. The series is entitled The Baby Boomer Business Owner Transition Guides. My first book in this Kindle series was recently published: Buy-Sell Agreements for Baby Boomer Business Owners. It is my third book on the topic of buy-sell agreements. It is a condensed and generationally focused version of my 2010 print book, Buy-Sell Agreements for Closely Held and Family Business Owners.  

At the request of several financial planners and attorneys, I am in the process of revising and expanding the original The One Percent Solution (available as a complimentary pdf download).  You can follow along because I will be writing installments on the topic for the blog as the new book develops. The new book will be the second book in The Baby Boomer Business Owner Guides series.

Conclusion

If you have ideas or thoughts you would like to share about managing private wealth, please feel free to call or email me.  I’d love to hear from you and consider your ideas as the new The One Percent Solution progresses.